The VC Series – Restrictive Covenants

‘The VC Series’ is a series of articles aimed at founders who are thinking of raising funds from venture capital investors. Further information about The VC Series can be found here.

This article explores how restrictive covenants work, why they are important to VCs, and the areas that founders should pay particular attention to.

What are Restrictive Covenants?

Restrictive covenants are provisions contained in the Investment Agreement that limit the activities of the founder(s) (and potentially other key employee shareholders) both during and after their involvement with the company.

They are often similar to those that you would expect to see in a founder’s service agreement, but in the Investment Agreement (i) are linked to the time of the founder’s shareholding, not just the founder’s employment, and (ii) are more likely to be enforceable, as the founders are giving the covenants in their capacity as a shareholder in consideration for the investment that the VC is making (rather than just as an employee).

Why are they important to VCs?

When VCs are investing in a company, they are to a large extent backing the founder(s) and the senior management team.

The founder(s) are almost always the repository of much of the key information relating to the company (whether that be market knowledge, its technology, or relationships with customers and suppliers), which from the VCs’ perspective makes it vital that they guard against any negative consequences of the founder(s) ceasing to be involved in the company.

What do Restrictive Covenants cover?

The restrictive covenants typically restrict the founder(s) from the following:

• competing with the business of the company for so long as he is involved with the company and for a period afterwards (also known as a ‘non-compete’); and
• for a period after they cease to be involved with the company:
  • solicit, or have any dealings with, any customers, clients or suppliers of the company
  • solicit, or have any dealings with, any key employees of the company
  • represent himself or herself as being involved in the company in any way.

Key Points for Negotiation

Whilst it is perfectly usual for a founder to be bound by restrictive covenants in this way, it is still important that the right balance is struck.

Key points that are often the subject of negotiation are:

• how long should the covenants apply after the founder(s) cease to be involved with the company;
• the activities that the founder(s) are restricted from being involved in; and
• the geographical scope of the non-compete.

We can help talk you through the consequences of these provisions and make sure that the restrictive covenants that you agree with are as reasonable as possible.

The VC Series – Next Article

The next article in The VC Series looks at preference shares, the share class that a VC will typically subscribe for.

You can find details of all the different articles in the VC Series here.

If there is anything that we have not covered which you would find useful, then please let us know.